January 21, 2011

Is California’s Debt as Bad as Greece’s?

Amid the concerns over public sector financing, many folks are worried about the quality of state (and municipal) bonds and the probability of default. Certainly, we’ve been writing about this, and as my colleague Mark Muro alluded in his recent post, there is a rather interesting and precise way to understand the risks of government solvency--analyzing the credit default swap market.

As analysts of secondary markets know, like the late Salih Neftci, credit default swaps essentially allow market actors that are heavily exposed to debt in the form of bonds--e.g. banks and institutional investors--to hedge against the possibility that the bond issuer will restructure payment or default. It is akin to an insurance contract, in that the buyer makes a regular payment in exchange for compensation if an unlikely even occurs--the bond issuer defaulting, in this case.

That regular payment is a percentage of the contract amount and is called the spread. This spread is a measure of risk and be used by analysts to deduce the probability of default over a given time period. Market information, therefore, offers extremely valuable insights into the health of bond issuers--like states and municipalities. Unfortunately, the latest publicly released data is rather disturbing for some states.

Using data released by Credit Market Analytics (CMA) from the third quarter of 2010, this table shows the probability of default for various countries and U.S. states. Remarkably, investors view Illinois and California as some of the most risky sovereign debt issuers in the world--even more risky than Spain and almost slightly less risky than Iraq.

The probability of default or restructuring over the next five years is viewed as 21 percent for Illinois and California. Michigan is nearly as high, and Nevada’s risk comes in at 16.7 percent, or 24th in the world, among these traded entities.

By contrast, the probability of default for Texas is only 7 percent, and the United States’ probability is put at just 4.2 percent. In other words, debt issued by California and Illinois are seen as five times riskier than debt issued by the United States government. Nevada is considered 4 times riskier. Interestingly, Argentina, despite rapid GDP growth, is high on the list--probably because it did default in 2002. Greece’s odds of default are put at roughly 50-50.

So, what explains these risk ratings? Well, the Pew Charitable Trust has a State Government Performance Project. State financial management is one of the indicators that receives a separate grade and is based on the following: “the degree to which a state takes a long-term perspective on fiscal matters, the timeliness and transparency of the budget process, the balance between revenues and expenditures, and the effectiveness of a state’s contracting, purchasing, financial controls, and reporting mechanisms.”

As it turns out, these somewhat subjective rankings from the Pew researchers are highly correlated with the risk premiums implicit in the credit default swap markets (the correlation is 0.78 for the sixteen states with data released by CMA). For example, Virginia gets an A- from the Pew staff and a probability of default is just 5.2 percent according to CMA data. Meanwhile, California and Illinois receive a D+ and C- respectively.

Even if the states don’t default, they face higher borrowing costs when analysts recognize that their short and long-term financial planning doesn’t add up. As of now, big states like California aren’t quite as distrusted as Greece, but they are approaching Portugal and Ireland.